In 2006 Artisan International earned 26% and Artisan International Small Cap earned 33%.
Here is a research report of Artisan International by Advisor Intelligence also known as Litman/Gregory. It is copyrighted material and should not be reprinted.
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Libby Mihalka
The Financial Pragmatist
FUND UPDATE: Artisan International Fund (ARTIX)
Category: International Growth at a Reasonable Price Managers: Mark Yockey Date of Interview: 10/05/06 With: Mark Yockey, Morten Aarnseth (analyst), and Stephen Chan (analyst)
Japan has underperformed other international markets this year but this has not diminished Yockey’s enthusiasm for its stock market. He continues to see investment opportunities in
Japan and currently has 23% of the fund’s assets invested there. According to Yockey, there are positives stemming from Japan’s transition from deflation to mild inflation. In deflation, where prices of goods are generally falling, consumers tend to postpone spending with the hope of buying at lower prices in the future. However, inflation, where prices of goods are generally rising, changes that mindset and encourages spending. Not only is this change increasing Japanese companies’ sales, it is also enabling them to raise prices. As a result, “Japan Inc. right now is more profitable than it’s been probably since the mid-80s,” observes Yockey.In Japan, Yockey likes the financial area and has close to half of the fund’s Japan allocation there. He highlights banks that are restructuring by reducing costs—for example, using more technology to improve productivity—and expanding into fee-based businesses, such as private banking where they provide financial advice to wealthy Japanese. The fee-based business is much more profitable than the traditional bank-lending business. “We think that stream of earnings is worth a lot more money than a net-interest-income stream,” says Yockey. His view is influenced by the similarities he sees between Japanese banks and some U.S. banks who implemented similar steps over 20 years ago, which helped improve their profitability.
Another attraction of Japanese banks is the improved prospects of their traditional lending business. Yockey believes Japan’s interest rates will rise as inflation takes hold in the economy and higher rates will help the banks’ lending business by increasing their net interest margins (NIM), i.e., the difference between the income from lending and the expenses incurred to attract deposits, expressed as a percentage of bank’s earning assets. Japanese banks currently pay close to zero on their deposits because they have “excess deposits.” Deposits are in excess because the Japanese typically save a lot and lending opportunities have been scarce for the past several years. So, there is no incentive for Japanese banks to pay higher rates to depositors (to attract deposits) when interest rates rise, although this may change as Japan’s economic cycle matures. On the lending side, Yockey expects lending rates to go up modestly as interest rates rise, increasing banks’ NIM as a result. There are two reasons why he thinks lending rates will go up. If Japan’s economy improves as Yockey expects, companies will be encouraged to borrow for capital expenditures and grow their business, and the increased demand for loans will put upward pressure on lending rates. In addition, Yockey says that Japanese banks are pricing their loans according to their risk levels rather than based on “relationship banking,” which used to be the norm historically. He notes that NIM for many Japanese banks are very low (around 1.1%) and even a small improvement will significantly improve their earnings.
One bank fitting this mold is Mizuho Financial Group, a top-10 holding in the fund. Yockey expects its fee-income business to grow at a rate of 15% to 20% per year and NIM to improve by about 10 to 20 basis points over the next two years, resulting in earnings growth of about 10% over the next few years. This earnings growth is in line with a typical U.S. or European bank, and much higher than the bank’s own recent history. Mizuho trades at 12x next year’s earnings, similar to what its U.S. and European counterparts trade at. Yockey believes it should trade at 15x to 16x earnings because Japan’s interest rates are much lower than in the U.S. or Europe, making its earnings more valuable. A risk to Yockey’s thesis is that fee-income growth comes in below expectations. Yockey and his team are monitoring the bank’s investment-trust sales to ensure fee income grows in line with their expectations.
For the past several years Yockey has been buying oil and gas companies that are producing oil and gas at a faster rate than their peers. In a period of rising oil prices, such companies have generated higher earnings growth. Examples of such companies include Encana, Lukoil, and Eni SpA. In recent months, the share prices of these companies rose to a point where they were less attractive relative to their future earnings growth. As a result, Yockey trimmed Encana and Lukoil, and sold Eni out of his portfolio. Aside from valuations, Eni was sold because its production growth had slowed, and Yockey’s energy analyst, Morten Aarnseth, expects it to slow even further. Eni’s high production rate was an important factor behind its initial purchase.
A new addition related to the oil sector is Technip SA, a French engineering and construction company serving the oil industry. With traditional sources of oil dwindling or becoming difficult to access, due to technical difficulties or politics, many oil companies are focusing on “unconventional oil and gas reserves” such as LNG (liquefied natural gas), deepwater oil sources, oil sands, etc. Aarnseth says Technip is a market leader in providing products and services in these areas. Recently, its stock sold off on a profit warning, providing a buying opportunity. According to Aarnseth, Technip’s profits declined more than expected because it had experienced cost overruns in projects it entered into in 2002 and 2003 when oil was around $30 per barrel. As oil prices went up, it was late in getting price guarantees from its subcontractors, which led to cost overruns. Having met with Technip’s management, Aarnseth is confident that Technip’s pricing discipline has improved and that it will execute on high-price orders in the future. He thinks investors are not factoring this in their earnings estimates and, therefore, sees more earnings upside than reflected in their estimates. Technip’s stock currently sells at a discount of 10% to 30% relative to its peers. If its management executes on its pricing discipline per Aarnseth’s expectations, he sees this discount narrowing.
The fund’s weighting in utilities has risen from 5% to 8% over the past six months as Yockey has added to some existing holdings in this area. One such holding is Fortum Oyj, a Finnish utility company. Historically, power has been priced at a discount in Finland and neighboring Scandinavia relative to the rest of Europe. According to Yockey, this price discount should narrow as Europe moves towards a single liberalized electricity market, boosting Fortum’s earnings. Already, prices have gone up from 30 euros/MWh to 45 euros/MWh, but he expects them to go even higher. He says there is an electricity shortage in Europe and very little new power capacity is expected to come on line in the near future, which should keep power prices relatively high across Europe. Commenting on why this stock remains attractive, Yockey says that Fortum did not expect prices to rise as much as they did and, therefore, sold most of its power for this year at lower prices in the forward market. However, it will start benefiting from higher power prices late next year and the following year, which investors are not yet fully discounting in their earnings expectations.
The fund has about 14% in emerging markets. Most of this exposure is concentrated in South Korea and China. In Korea, a large holding is Kookmin Bank, which is benefiting from its move to fee-income business, similar to its Japanese counterparts discussed above. In China, while there is no particular theme, most holdings there are benefiting from the country’s rapid economic growth. One example is China Life Insurance Co., a new position initiated in the fund in the third quarter. Chan says that with the Chinese economy growing at about 10% per annum incomes will rise, making life insurance more affordable for its citizens. He thinks the Chinese insurance market has a lot of room to grow as China’s economy develops. He notes that on average China spends 2% of its GDP on life insurance, much lower than 5% globally and 8% to 10% for other more developed Asian countries such as Korea and Singapore.
Litman/Gregory Opinion
Year to date through October, Artisan International Fund is up 16.7% compared to an 18.4% return for Vanguard Total International Stock Index Fund. Despite outperforming its index in 2005, the fund lags over the trailing three and five years, largely due to an 11-percentage-point performance deficit in 2003 when picks in the financial and media sectors and an underweighting to emerging markets hurt performance. Longer term, the fund’s track record remains impressive. Over 10 years (through September) the fund is outperforming its index by six percentage points, annualized, although this includes 1999 when the fund outperformed its index by 51 percentage points. We also look at Yockey’s track record going back to July 1990, which includes his history at Waddell & Reed. Since July 1990, Yockey has beaten his benchmark by six percentage points, annualized. In addition, he has shown good performance consistency over longer periods, finishing ahead of the index in 70% of rolling three-year periods and 84% of rolling five-year periods. This performance has come with slightly higher volatility than the index, but it is superior to the index on a risk-adjusted basis (i.e., Sharpe ratio). We caveat Yockey’s long-term record by noting that he managed a smaller asset base during the early years and could pick stocks across a wider range of stock-market capitalization than he can now. While a larger asset base diminishes Yockey’s ability to add value the same way he did in the 1990s, we believe his opportunity set is broad enough to allow him to beat his index over the long term.
We also compare Artisan International’s performance to MSCI AC World ex U.S. Growth to account for the fund’s growth orientation. While over five years the fund trails this index by 1.6 percentage points, over seven years (we do not have returns for the index beyond seven years in our database) it is ahead by 5.9 percentage points, annualized. Versus its peers, Artisan International has generated roughly median performance in both the international growth-at-a-reasonable-price and international growth categories over the past five years. We note that the fund, while diversified across 80 to 120 holdings, can take significant sector and country bets versus its index. For example, the fund has about 8% of its assets in the U.K versus an index weight of over 20%. As a result, its performance can be out of sync with its index over long periods.
There have been two new additions to the investment team this year—Tony Kim and Laurie Fitch. The team now comprises 10 individuals, including Yockey. Kim will cover the technology sector while Fitch will focus on utilities and infrastructure. We will speak to these analysts in the coming months.
Recently, we spoke with Aarnseth and Stephen Chan, both analysts who joined the team last year. Our discussions with them reinforced several key points that drive our positive opinion on Artisan International. Yockey has surrounded himself with experienced analysts who are impressive in terms of their knowledge of their sectors and companies. While quality of the analyst team is important, of even greater importance is Yockey’s involvement with his analyst team on a day-to-day basis and his focus on investing, which helps him act as a filter for ideas. This is because we believe his ability to understand business models, his independent thinking, and his ability to profitably synthesize macro factors at the company level gives him an edge over his peers. We think Yockey is very accessible to his analyst team to discuss ideas and remains engaged and passionate about investing. We continue to recommend Artisan International Fund.
—Rajat Jain, CFA
_________________________________________________________________________________Reprinted AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.
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